What has been the overall impact of the new tax law on real estate?
LK: Specific programs were put into the Tax Act to spur job creation and economic growth in certain areas and in designated communities. The Act gives certain benefits to the real estate community while making sure it can put money back into infrastructure, create jobs and create a better living environment for people. It’s no surprise that the new act benefits the real estate community because of this focus.
Could you give some examples?
LK: Some of it is on a personal level. The deduction for mortgage interest is limited. The deduction for state and local property taxes not involved with a trade or business or the production of income and state and local income taxes are together capped at $10,000 for married taxpayers filing jointly. And, miscellaneous itemized deductions are no longer allowed. All of those individual provisions are going to have an implication on how real estate private equity funds are going to be structured.
The typical family office or individual investor is going to look for different things when they’re making investments, knowing they can’t get those deductions from a flow-through entity structure. When you look at a real estate private equity fund or any type of fund, you have to look at the investor profile first and see what those investors are going to be looking for – for income and for deduction.
What are some of the implications for real estate investment trusts?
LK: REIT investors are afforded a 20 percent reduction of income. Putting a REIT under a fund means investors do not have to file in multiple states, because they’re going to get a dividend, which is only reportable in their home state. Their tax return can be easier to prepare.
The 2 percent management fee, to the extent it’s a property management fee, can also be deductible at the REIT level. The REIT is going to cleanse some of the things that you are losing in deductions through the pass-throughs and it’s going to give you a lower tax rate.
A year ago, the individual investors didn’t really want REIT dividends because they were taxed at a higher rate and they wanted the benefits of flow-through activity; they wanted pass-through losses. Now individual investors have changed their minds and are more willing to go into a REIT environment.
What are you telling your real estate clients as a result?
LK: We always tell people to make sure that documents are flexible enough so that they look at what their investor profile is going to be, and they make sure that they can adapt to whoever the investor is. Some investors are going to come in with larger capital commitments, and they might want something to be set up specifically the way they need it to be.
You can make provisions to protect investors and give them the benefits. People want to see that you’re understanding what their tax implications are and that you are sophisticated enough – that you’re getting the information and working with your accounting firm, law firm and fund administrator.
The individual or family office, which didn’t really benefit from the REIT structure in prior years, are now getting the benefit as well. For friends and family of these types of structures, it’s an easier conversation to have than a year ago because the REITs were not beneficial for them.
We’re out there talking to our real estate private equity clients both in the equity and debt space. Most of them are exploring it if they don’t already have it in their structure. If they are not able to utilize it, it’s for a really good reason. We’ve now had conversations with every single one of them. Maybe they don’t want to convert their prior funds but they could make the change for their next fund. These are conversations that have always been happening but now make even more sense.
What are some of the new opportunities under the Act?
LK: There’s the qualified opportunity fund and the qualified opportunity zones, which were set up under the Act. All 50 states, all five territories, Washington, DC and Puerto Rico have qualified opportunity zones.
This is to spur economic growth in low-income distressed communities, and not only does it give opportunities for both real estate and development, there are also some benefits in there for businesses.
A qualified opportunity fund is a corporation or a partnership that is specifically designated. There’s a self-certification process that you’ll be going through.
How does it work?
LK: A taxpayer who has a capital gain that’s been realized can take that gain and invest it in a qualified opportunity fund. That gain is not currently taxed. You have 180 days to do that. It’s not the proceeds, it’s the actual gain itself. That means you don’t have to reinvest your basis. It can be a gain from a stock, mutual fund, or artwork. Any gain. You can take a gain from your personal residence. If you hold the fund for five years, you reduce that gain by 10 percent. If you hold the fund for seven years, you reduce that gain by 15 percent. If you hold the fund for 10 years, all appreciation on the invested gain is excluded from tax. It’s a great deferral and exclusion provision.
Qualified opportunity funds have to have 90 percent of their assets in qualified opportunity zone stock or partnership interests or business properties. These can be a business, apart from sin businesses, in one of these zones. If you have a fund created for this business and you have investors putting money in, they’re allowed all these perks. It can also be real estate but it is a little different because you have to actually improve it. You have to put in a dollar more than your adjusted basis. You have 30 months to do the improvements, but we need more information on start date and end date to know how they’re going to be counting those 30 months.
Are there other downsides to the qualified opportunity funds?
LK: The concerns are from a policy standpoint. If you have not sold your interest in the qualified opportunity fund by December 31, 2026, the original deferred gain, subject to the 10 or 15 percent reduction if available, will be recognized and taxed at that time. But what’s going to happen when you need the cash to pay for that? Is everybody going to exit? And then what do we do to these distressed communities? We don’t know. We need more guidance from the Internal Revenue Service on that and other details.
Lisa Knee is a tax partner at EisnerAmper and the firm’s national leader for the real estate private equity group.
The article is sponsored by EisnerAmper. It appeared in the September 2018 issue